Saturday, May 06, 2006

How Not to Invest

THE DOW INDUSTRIALS ROSE more than 120 points to their highest level in more than six years as traders weighed nonfarm payrolls data and Warren Buffett's next move.

—Wall Street Journal Online

That was the explanation for Friday’s market rally on the WSJ online edition during the late afternoon.

The Journal may have been right about the reasoning behind the rally, but buying stocks based on Warren Buffett’s purported acquisition plans is a heck of a lousy way to invest.

While Buffett did indeed make a “move”—announced yesterday at his shareholder’s meeting—it was not what those traders were looking for. Instead of a nice, big, juicy, all-cash deal at a huge premium for one of those thirty Dow Jones Industrial companies, Berkshire Hathaway announced it is taking an 80% stake in an Israeli metalworking company.

Worse, for those traders at least, Buffett told the faithful at his shareholder meeting that he remains bearish on the U.S. Dollar and is more interested in making new investments outside the U.S. as opposed to in.

Meaning that a $15 billion acquisition, which Buffett also disclosed he is working on and appears to be the anticipated deal everybody was front-running on Friday, is certainly not likely to be any one of the 30 components of the Dow Jones Industrial Average that was bought in anticipation of Buffett’s “move,” nor even a NASDAQ-listed company.

In any event, the notion of buying stocks because Warren Buffett is looking to make a large acquisition is one of the least appealing reasons to invest that I can fathom, although buying a stock that might appeal to Warren Buffett--say, for its high return on equity, business "moat," excess cash flow and simple operating model--is certainly one of the best.

Those Friday traders might want to consider that Buffett recently sold a large market “put” with a reported maximum notional exposure of $14 billion—meaning that if the indices covered by the put contracts fall to zero in the next 15 to 20 years, Berkshire would lose $14 billion.

While it might look on the surface that Buffett’s huge sale of market puts with a 15 to 20-year time horizon represents a positive bet on the trend in equity prices—after all, he loses money only if the market goes down—it is actually a brilliant way to accomplish what Buffett most fervently wishes for: the ability use Berkshire’s $40 billion cash hoard to buy stocks at drastically reduced prices.

If the market goes up, the puts Buffett has sold expire worthless, and he’s had the use of that cash for many years, at no cost to Berkshire.

If, on the other hand, the market collapses, Berkshire will be “put” a large basket of stocks at dramatically lower prices, and Buffett will have put his cash hoard to work at the kind of prices he has been waiting patiently for.

Either way, Buffett wins in a big way.

Which is more than you can say for most of the traders speculating on whatever Warren Buffett might announce at his weekend shareholder meeting.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


The Unknown Broker said...

So Jeff, given your positive comments on the Buffett put selling strategy, shall I assume that you'd like to write some out-year puts yourself? Perhaps a few billion dollars less than Uncle Warren, but a position size worthy of a hedge fund mucky-muck such as yourself?

Call me. Baby needs a new pair of shoes.

Seriously, I do believe that put writing is a largely misunderstood and underutilized strategy. When done in appropriate size it becomes, in essence, being paid to put in a limit buy order.

Done incorrectly of course it becomes over-levered speculation and that is where most dabblers get clobbered.

Aaron Koral said...

Jeff - While I agree that "front-running" Warren Buffett's next investment move is impossible to discern, I must respectfully disagree with the title of your post, "How Not To Invest". The title seems to imply that making investments outside of the US seems like a bad way to invest one's money.

Berkshire Hathway (BKH.A) has been an incredible investment for its investors from inception. The average annual gain from 1964 to 2005 has been 21.5%. Compared to the S & P's average annual gain of 10.3% in the same period is quite an achievement.

In BKH.A's 2005 annual report, one should notice a majority of those gains have come in recent years from business acquisitions in the US. BKH.A purchased companies such as NetJets, Shaw Industries and Benjamin Moore, just to name a few, that recently have been accretive to earnings.

IMHO, I think BKH.A will continue to purchase businesses in the US, as well as those outside of the US denominated in foreign currencies, so long as those businesses can "widen their moats", as Mr. Buffett so eloquently puts it in his shareholder letters.

If the dollar continues to weaken (note that the dollar hit a new low against the Euro in currency trading recently - I am not making that up; check Bloomberg for an article on this subject), companies outside of the US with international sales should do well.

P.S. - If one, however, were to "front-run" Mr. Buffett's next investment move, I would be looking VERY closely at the Utility sector and those companies that do business out West in the US (I could be wrong though...)

Private Uly said...

Jeff, I don't quite understand your point about 'either way, Buffett wins in a big way'. If the market collapses, sure, Berkshire will inherit a large basket of stocks valued at low prices. However, Berkshire will be paying for them at the put's strike price (presumably, today's high prices?) and not at those low prices. So, won't there be a big loss for Berkshire?

zephyr said...

It is true that Berkshire Hathaway has been an incredible investment from inception... But very unexceptional in the last five and ten years.

Jeff Matthews said...

"Private Uly": By selling the put, Buffett keeps the premium until the time comes when, should the market collapse, he gets put the market indices at whatever strike price he's sold.

Presumably, Buffett has sold puts at low strike prices that would, in his view, represent good buys.

trying to be not stupid said...

"It is true that Berkshire Hathaway has been an incredible investment from inception... But very unexceptional in the last five and ten years...."

Sorry to be so late posting, but i'm catching up on my reading... anyway, best as i can tell, trailing 5 years thru the end of May looks like the Berkshire stock price has increased about 35% while the S&P has barely managed a gain.... while that is only a 6.2% annualized return, given the bear i'd call it exceptional.